Rethinking the way we invest in Aussie tech
Investing in Tech companies has many caveats from traditional investing. Let’s dive into how you can gauge the true profitability of a tech company.
Given all the hype around the Magnificent 7 it is unsurprising that many Aussie investors overlook the rapidly growing tech sector on home soil. The digital technology market in Australia has grown 80% over the past 5 years and this growth is accelerating.
Investing in the tech sector differs from ‘traditional’ investing. For one, the profitability metrics used to find ‘winners’ vary from non-tech companies. This is due to the Software as a Service (SaaS) subscription model which has some unique characteristics.
Traditional metrics don’t work
Using traditional profitability tools such as Return on Invested Capital (ROIC) underestimates the true profitability of a software business. The reason for this comes down to accounting principles. Without boring you with the details, lets instead go through an example that might be more relevant in your day to day review of investment opportunities.
Think of your Spotify subscription. Spotify spends money on advertisement and promotional offers to get you to subscribe. All of these expenses are recorded as a cost on the income statement in the current year. A hypothetical customer uses Spotify for 10 years based on the utility of the service and inertia. Spotify only records the revenue from your subscription for the first year, which ignores the lifetime value of your subscription (think of the total sum of payments over 10 years).
The mismatch between lifetime value of the customer and the upfront acquisition costs distorts the true profitability of the company. This disconnection is amplified in high quality SaaS companies with long customer life cycles. This is where alternative profitability metrics come in.
The two methods for investors to consider are the Rule of 40 and Investment Payback Period. These two metrics were explored in detail by Morningstar Equity Analyst Dr. Roy Van Keulen in his report “Uncovering the Hidden SaaS Profits”.
With Roy’s help, I will compare two Aussie tech companies using these metrics. My review will demonstrate the different profitability metrics in action and enable you to apply these metrics in your own investment strategy. But first, let’s have a better look at the Rule of 40 and Investment Payback Period.
What is the Rule of 40?
The Rule of 40 is a metric used primarily for SaaS companies. To calculate the Rule of 40, you add revenue growth and profit margin percentages for the current year. A sum of 40 or higher is considered a strong score. For example, Company A has revenue growth of 25% and a profit margin of 15%. The sum of these two percentages would get a total score of 40. Venture capitalists Brad Feld and Fred Wilson first popularised the Rule of 40 in 2015 and it has since been widely adopted as an alternative profitability metric.
The Rule of 40 is balancing profitability and growth. In a hyper growth stage profitability is secondary as the company gains market share. However, once growth slows it is critical for profit margins to increase.
The drawback to the Rule of 40 is that it only gives investors context for the current year. For example, if a company invests heavily in a new project - the revenue from that new project is unlikely to be seen in the first year.
This means that it has a bias towards near term profitability. Therefore, the Rule of 40 is most useful for a SaaS company in early maturity (think midlife). The good news is the vast majority of the big ASX tech names reside in the early maturity segment such as WiseTech, Xero and TechOne.
Using Investment Payback as an additional tool
The investment payback period considers the time it takes for a company to earn back the costs of their investments. Intuitively the faster a company can recover investments through profits, the better. To calculate the Investment Payback Period, first sum the internal investments in Sales & Marketing and R&D. Then divide this by incremental gross profit (current year gross profit minus previous year gross profit). The answer is expressed in years – which we can compare to competitors. If the Investment Payback Period is 3, then it will take 3 years for the company to earn back their investment.
For investors in the technology sector, this is an important diagnostic tool that can be used alongside the Rule of 40 to analyse the efficiency of a tech company. The investment payback calculation is best suited for SaaS companies in the early growth phase to early maturity. Ideally as investors, we want a higher Rule of 40 score and lower Investment Payback Period score.
With a solid grounding in what the two metrics aim to achieve, it is time to put them to the test. With the help of Roy, I will run two well-known Aussie SaaS businesses through the metrics and compare.
Xero (ASX:XRO)
- Fair Value Estimate: $100 (22% premium at 27 November)
- Rating: ★★
- Moat: Narrow
Xero was an early mover in cloud-based accounting software for small businesses in New Zealand. The company expanded its operations to Australia in 2009 and is now a dominant leader in the region. Roy estimates that Xero have roughly 60% market share in Australia and 80% in New Zealand across SMEs. The benefit of being an early mover is the broad network effects that Xero have developed over time.
Rule of 40 score: 47.88
This is a strong score – passing the benchmark. While Xero’s revenue growth has slowed over the past few years, it is still holding at around 20%. Conversely, the FCF margin has improved significantly overtime to 27.42%. The key concern for Xero as highlighted by Roy is the room for growth. Maintaining high revenue growth for maturing technology companies such as Xero is difficult without a clear runway for growth.
Investment Payback Period: 3.5
This is another solid score. Roy calculates the payback period as 3.5 which is relatively in line with previous years. An improving payback period overtime suggests improvements in efficiency of investments. However, Xero has remained relatively flat which is in line with our analysts expectations.
SiteMinder (SDR:ASX)
- Fair Value Estimate: $10.75 (39% discount at 27 November)
- Rating: ★★★★★
- Moat: Narrow
SiteMinder is the world’s largest e-commerce software platform for the global hotel industry. The company provides SaaS to accommodation providers to assist them in managing online bookings, revenue and guest experience. They also connect their accommodation providers with online booking channels; think of Booking.com and Expedia.com. SiteMinder is one of the few ASX tech companies in our coverage that falls into the early-stage category as it has a longer runway for growth. Therefore, we can expect that the Investment Payback metric will be most suited.
Rule of 40 score: 16.24
This score is below 40 but this is not a surprise. Due to SiteMinder being in an early growth phase, they are currently not profitable. The FCF to sales margin is -1.41% which is the profit margin we use in our calculations. I have added this to the 17% revenue growth this year and arrive at 16.24. With double digit revenue growth, it’s clear that the FCF margin brings down the total score. This is common for a lot of early phase SaaS companies. With the FCF margin expected to improve over time, we can expect the Rule of 40 score to improve with it.
Investment Payback Period: 5.7
SiteMinder’s score is higher this year but is expected to improve. SiteMinder has scored between 4 and 5 over the past three years. Scores in this range are strong considering SiteMinder has invested heavily in new products in recent years. Roy expects this score to improve further as the benefits of SiteMinder’s investments in new projects such as Channels Plus flow through.
Wrap Up
There are two important lessons. The first being that as investors, we need to look at technology shares through a different lens. Hopefully you now understand that the nature of SaaS models has a distortion effect on normal profitability metrics. Secondly, this exercise demonstrated how you can use alternative metrics to gain better insight into the health of a SaaS company. The Rule of 40 and Investment Payback Period are two tools you can use to contextualise and compare investment options in the Aussie Technology sector.
